The Unlikely Effects of USD Depreciation

Even if the dollar depreciates sharply in the near term, adverse effects are
unlikely—primarily because inflation will stay low.

Pundits and policymakers around the world are wringing their hands over the
possibility of further declines in the foreign exchange value of the dollar.
Predicting exchange rates is notoriously difficult; there is almost as much
chance of the dollar rising next year as of it declining. But if the dollar were
to fall further, should we be concerned?

A lower dollar is good news for US exporters and foreign importers and bad
news for foreign exporters and US importers. However, if policymakers respond
appropriately, there is no reason to fear overall harm either to the US economy
or to foreign economies.

Indeed, a lower dollar could jumpstart the long-overdue rebalancing of the
global economy away from excessive US trade deficits and foreign reliance on
export-led growth, putting the world on track for a more sustainable
expansion.

The fear in economies that are appreciating against the United States is that
a falling dollar will choke off exports and hobble economic recoveries. The
correct response is to ease monetary policy and temporarily delay fiscal
contraction. As I explain here, even in economies with short-term interest rates
near zero, there is plenty of scope for central banks to stimulate aggregate
demand, and doing so will help to limit the extent to which the dollar
falls.

For the United States, the benefits of a falling dollar are obvious: Stronger
exports and a faster recovery. The fear is that a falling dollar would be
inflationary. However, as I have shown in two recent papers, even very large
currency depreciations in developed economies have no effect on inflation unless
they are caused by policies that attempt to hold an economy's unemployment rate
below its equilibrium level.

With US unemployment currently at 10%, there is no chance that inflation will
rise in the near term. Whether inflation rises in the longer run will depend on
whether US monetary and fiscal policy stimulus is withdrawn appropriately as the
economy recovers (and tighter macroeconomic policies would tend to support the
dollar). Many believe that US policymakers erred in not withdrawing
stimulus soon enough in 2003-2005, but policymakers now seem to be keenly aware
of this mistake and have expressed their determination not to repeat it.
Only time will tell, but my own view is that the Federal Reserve, at least, will
not allow runaway inflation.

For economies that peg their currencies to the dollar (notably China), the
costs and benefits of a falling dollar are the same as those facing the United
States, and so is the policy dilemma: How fast to tighten macroeconomic policy
as the economy recovers? These economies differ on several dimensions, including
financial market development and capital controls, strength of economic ties to
the United States, and prospects for economic slack and inflation. These
differences will determine the appropriate policy stance. To some extent, these
economies have forfeited the freedom to adjust monetary policy, but they retain
the option of adjusting the levels of their dollar pegs. In some cases, a
further decline in the dollar may represent an opportune moment to move to a
floating exchange rate.

By Joe Gagnon, Peterson Institute for International
Economics

Joe Gagnon is a senior fellow at the Peterson Institute for International
Economics. Joe is an expert on international economics has spent a great deal of
time studying the effects of exchange rate depreciation.